Gold Mining Stocks Are An Increasingly Attractive Opportunity

At their essence, gold mining profits reflect the difference between industrial commodities and gold, rather than the price of gold itself.(Photo credit: ˙Cаvin 〄)

By Daniel Oliver

Gold has been one of best performing asset classes of the millennium, but gold stocks have lagged. Whereas gold has returned 471% since September 2000, the S&P/TSX Global Gold Index’s total return is only 233%, which is particularly disappointing because gold stocks are supposed to provide leverage to the gold price.

In a recent Wall Street Journal article, Andrew Peaple and Liam Denning quantify the failings of gold miners. Over the past decade, they write, the four biggest gold mining companies – Barrick, Newmont, Newcrest, and Goldcorp – generated $47.5 billion in operating cash flow. But, they spent $68.5 billion: $43.4 on net capital expenditure, $19.1 billion on acquisitions, and $6 billion on dividends, not to mention taxes. They funded this deficit by diluting their shareholders: the collective share count soared by 117%.

Peaple and Denning actually omitted the two worst sins of the gold producers. First, the problem with the acquisitions was not that they occurred, but that they were bad deals. Most egregious was Barrick’s $7.69 billion takeover of Equinox Minerals, a copper producer. Barrick did not attract any copper investors, but it did alienate its gold investor base.

Second, of the four companies listed above, all but Goldcorp engaged in extensive hedging. Even though the gold price and mining costs rose together, the gold companies were stuck selling at the low gold prices they had locked in. They had to spend billions unwinding these hedges. Why would any investor buy the stock of a company short its own product?

Looking at a different index of gold stocks reveals the damage hedging caused. The Amex Gold Bugs Index includes only those gold companies that do not hedge their production beyond eighteen months. This index has surged 717% since September 2000, handily beating other gold indices and gold itself.

Gold mining, like all other industries, depends not just on sound management, but also an understanding of the macro environment. For instance, it does not always pay for gold miners to be unhegded: in the period of 1996 to 2000, when gold was falling, the Amex Gold Bugs Index fell by over 75%.

Gold stocks are poised to make historic returns, but not for the reason most investors think. Global money printing may cause the price of gold to skyrocket, but the skill of predicting the long-term direction of gold stocks is more complicated than having an accurate forecast of gold prices. In fact, the gold price is almost irrelevant.

For any business, the profit margin is the difference between costs and revenue. Mining operations consume huge amounts of energy, energy related products such as tires, steel for the equipment, and other commodities. Gold mining also competes with base metal mining for labor and management. In other words, the costs of mining gold depend heavily on the prices of industrial commodities.

Gold mining revenues depend solely on the price of gold. Therefore, at their essence, gold mining profits reflect the difference between industrial commodities and gold, rather than the price of gold itself. After all, gold mining was wildly profitable at $35 an ounce in 1933, when oil was $0.67 per barrel.